Germany

World Economic Prospects, Autumn 2008

Highlights and Key Issues

* German GDP fell by 0.5% in Q2, after a surprisingly strong Q1. The weakness in Q2 was exaggerated by the abnormally mild winter boosting construction activity in Q1, and by the introduction of less favourable depreciation rules as part of the reform of business taxation at the beginning of 2008 - which encouraged investment to be brought forward. However, a decline in exports and private consumption indicates that the fall in GDP is down to more than statistical quirks.

* The Ifo index has dropped from 103.4 in May to 94.8 in August, and is now below its long-run average, corresponding to the levels seen in 2004. Both the current situation and future expectations components of the index have dropped sharply in recent months, with business expectations plummeting to their lowest level since 1993, despite an easing in the oil price and the euro. The near-term outlook is bleak and, with industry and exports falling in July, the economy is close to recession. We now expect GDP to expand by 1.6% this year and just 0.8% next, with risks skewed to the downside.

* Inflation seems to have now peaked in Germany: preliminary data put inflation at 3.1% in August, down from 3.3% in July. The main factor behind the decline in inflation is lower fuel costs. Inflation is set to fall through 2009 but still average 2.3% in the year as a whole. With wage inflation set to edge up, this will provide a welcome boost to households and help the economy strengthen in 2009H2.

Overview

The economy declined in Q2...

* German GDP fell by 0.5% in Q2, after a surprisingly strong Q1. This was the first quarterly decline in GDP since 2004Q3 when Germany was still struggling to emerge from several years of stagnation. The magnitude of growth in Q1 and the mirroring fall in Q2 are exaggerated as the abnormally mild winter boosted construction activity in Q1 and the introduction of less favourable depreciation rules as part of the reform of business taxation at the beginning of 2008 encouraged investment to be brought forward. However, a decline in exports and private consumption indicates that the fall in GDP in Q2 is down to more than statistical quirks.

...and weakness continued into Q3...

* Indeed, although industrial output edged up in June, this was a very disappointing rebound from the already extremely weak May, suggesting weakness persisted through Q2. Manufacturing orders continue fo plummet, falling 1.7% in July as orders for capital goods dry up. And the economy appears to have weakened further in August, as the PMI for manufacturing slipped below the 50-mark that separates expansion from contraction for the first time since 2005. According to the Ifo index export expectations are at their lowest since 2003, prior to the period of wage moderation that boosted Germany's competitiveness and another reminder that growth prospects for Germany have slipped back sharply.

...with economy close to recession

* The speed with which the economy is slowing is somewhat surprising: the Ifo index has dropped from 103.4 in May to 94.8 in August, and is now barely above its long-run average and corresponds to the levels seen in 2004. Both the current situation and future expectations components of the index have dropped sharply in recent months, with business expectations plummeting to their lowest level since 1993, despite an easing in the oil price and the euro. The near-term outlook is bleak and, with industry and exports falling in July, the economy is close to recession. We now expect GDP to expand by 1.6% this year and just 0.8% next, with risks skewed to the downside.

Unemployment to rise...

* And such a decline in the business environment will start to have repercussions in the labour market. Although unemployment continues to edge down, there have already there have been some high profile announcements of job losses. Also, survey evidence from the PMIs and Ifo employment barometer show businesses' employment intentions have cooled, while the number of vacancies is trending down - we expect unemployment to rise to 8.5% by end-2009. However, this is fairly typically in a cyclical downturn and the labour market remains in much better health than earlier in the decade.

...as unions demand wage hikes...

* Inflation seems to have now peaked: inflation was 3.1 % in August, down from 3.3% in July, while wholesale inflation dropped sharply in August, indicating an easing of pipeline inflation pressure. The main factor behind the decline in inflation is lower fuel costs. Inflation is set to fall through 2009 but still average 2.3% in the year as a whole. With wage inflation set to edge up, this will provide a welcome boost to households and help the economy strengthen in 2009H2. The outlook for wages is a key risk to the outlook- both for inflation and growth. The IG Metall union is demanding a 7-8% wage increase in the upcoming wage round, its most aggressive demand in 16 years. However, against a likely backdrop of rising unemployment and weak growth, unions are unlikely to achieve their objectives.